Monday, July 13, 2015

The elusive rate hike

We are now firmly 7 months into a projected rate hike that moves pretty linearly ahead in time, so that we are always 6 months away from the first hike. This has happened with the end of each phase of QE. Notice that the slope of the yield curve also appears to be declining over time as the elusive rate hike date keeps pushing into the future. I believe that this reflects the fear that we will not leave the zero lower bound, or will return quickly to it.

It is worth keeping in mind that, from a pure expectations point of view, the zero lower bound will cause the yield curve spread to be inflated because there is a lower limit on the range of forward expectations. If short term rates were at 5% and the yield curve flattened, this would reflect a range of rate expectations, some falling and some rising. At the ZLB, there is no space for falling expectations, and there will always be some segment of the market that expects rising rates. I don't think there is a way to measure the scale of this effect, but a rate market that is equivalent to a flat or inverted yield curve will still have a positive slope in this context.

This effect will diminish as we leave the ZLB. So, if the Fed does eventually push rates up prematurely, the yield curve should flatten sharply as short term rates leave the ZLB. So, with no rate hikes, the yield curve signal is difficult to read. But, if there is a rate hike, it should be more clear.
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Mortgage levels remain subdued. Recent attempts to loosen up mortgage lending appear to have stalled. It looks to me like the market for households with very good credit is strong, but mortgages are practically non-existent for FICO scores below a fairly high level. We are still burdened by an over-reaction to a phantom phenomenon.

You'll have to squint really hard to see an unprecedented expansion of housing credit in the 2000s here. I never cease to be amazed at the absurdity of so many today looking at home prices as if they are getting "bubbly" again, as if we have a demand-side problem. QE, at this point, is all sitting in excess reserves. The only way for that cash to inflate home prices at this point is through bank credit expansion, and that hasn't happened in residential mortgages for 5 years. Note that commercial mortgages, which aren't saddled with the demands of our public financial asceticism, are expanding at modest recovery rates, along with Commercial and Industrial Loans.

This is typical of the impenetrable wall built around the consensus view of the housing problem. When I report that FICO scores and incomes of average homebuyers were actually rising during the 2000s, the response is usually that this is a distortion. The FICO scores were deceptively high because households were living off of the capital gains of their rapidly appreciating homes. Once the "bubble" burst, the tide went out and those homeowners couldn't use their home equity ATMs any more, and their true credit risk was exposed.
﻿﻿﻿﻿Today, with even the slightest loosening of mortgage credit standards, there are snorts of "Here we go again." "Did you hear, they're starting it up again with the 3% down loans? Gotta keep that bubble economy going." If banks began approving mortgages for FICO scores that were the norm in any previous market, there would be outrage. In a way, you can't blame the regulators. Public opinion is sharply against having a functional, accessible mortgage market.

But, here's the thing. If anything, current FICO scores are skewed lower. Households have just made it through the toughest recession in at least 35 years. Many were unemployed. Homes lost huge portions of their value. If FICO scores were inflated in the 2000s, they are deflated now.

So, if we want to retain the "predatory lending" cause of the crisis by dismissing the high FICO scores of the 2000s, then we can't also justify such stringent standards in today's credit market.

I'm a voice in the wilderness, and this state of affairs isn't about to change. But there are two implications:

1) This will continue to create frictions in the housing market, which create supply-side inflation in housing consumption, low interest rates because of the lack of housing investment, and demand-side disinflation because of the lack of credit growth. None of this bodes well for catching our perpetual future rate hike.

2) Note in the Federal Reserve slide above, originations for FICO scores above 770 are still near boom levels. All FICO scores lower than that are below 2001 levels. I think it is especially interesting that originations for FICO scores above 800 shot up in 2004 and 2005, and have remained near that level to today, even through the deepest part of the housing bust. In effect, the misplaced fear of predatory lenders has created a housing market where the top quarter of households are buying up houses at significant discounts to intrinsic value and households below the median are stuck renting homes with ever increasing rents. The idea that homes are selling significantly below intrinsic value is not popular. But, it sure looks like households with FICO scores above 770 agree with me. They have been on a buying spree that has been unabated since 2005.

This isn't even a Baptist and Bootlegger problem. We are living in the naïve rentier economy. I don't think the top quarter of households are lobbying Congress to maintain credible threats toward the banks so a hobbled mortgage market keeps homes cheap for the lucky few. I suspect that many of them are complaining about the "bubble economy" even as they sign off on their new homes.